Lecture Multinational financial management - Topic 8: Carry trade and covered interest arbitrage. In this chapter, students can compute profits from carry trades and covered interest arbitrage, students understand the function and use of a credit default swap (CDS). | Topic #8: Carry Trade and Covered Interest arbitrage L. Gattis The Pennsylvania State University 1 Finance 407: Multinational Financial Management Review 2 The yen is selling at a 1% premium for one year delivery. . Treasury yields are 3%. What is the Japanese sovereign yield according to IRP? A. B. C. D. E. Learning Objectives 3 Learning Objectives Students can compute profits from Carry Trades and Covered Interest Arbitrage Students understand the function and use of a Credit Default Swap (CDS) The Yen Carry Trade 4 A “carry trade” in one in which you borrow a low interest rate currency and invest in a high interest rate currency. Throughout the 2000’s one of the most popular trades by hedge funds was the yen carry trade when Yen borrowing interest rates were less than 1% and . Treasuries were near 3%. Example (assume spot price remains constant at ¥100/$) Borrow 1 million yen at 1% for one year Sell ¥1 million for $10,000 (¥1,000,000/(¥100/$)) . | Topic #8: Carry Trade and Covered Interest arbitrage L. Gattis The Pennsylvania State University 1 Finance 407: Multinational Financial Management Review 2 The yen is selling at a 1% premium for one year delivery. . Treasury yields are 3%. What is the Japanese sovereign yield according to IRP? A. B. C. D. E. Learning Objectives 3 Learning Objectives Students can compute profits from Carry Trades and Covered Interest Arbitrage Students understand the function and use of a Credit Default Swap (CDS) The Yen Carry Trade 4 A “carry trade” in one in which you borrow a low interest rate currency and invest in a high interest rate currency. Throughout the 2000’s one of the most popular trades by hedge funds was the yen carry trade when Yen borrowing interest rates were less than 1% and . Treasuries were near 3%. Example (assume spot price remains constant at ¥100/$) Borrow 1 million yen at 1% for one year Sell ¥1 million for $10,000 (¥1,000,000/(¥100/$)) Invest $10,000 in 3% . Treasury that returns $10,300 ($10,000*) Repay Yen loan ¥1,010,000 (¥1,000,000*) which costs $10,100 (¥1,010,000 /100) Earn $200 (10,300-10,100) or 2% (10,300-10,100)/10,000) profit. As long as exchange rates do not change when its time to payoff of the yen loan, you can borrow at 1% and invest at 3%. Effects Kept yen values low (hedge fund selling of yen, buying dollars) Created systematic risk to the appreciation of the yen (there was an estimated $1 trillion on the yen carry trade in 2007) What is the risk of this trade? The Yen Carry Trade: Example 2 5 According to IRP, the expected spot price of the yen in one year when . and Japanese sovereign yields are 3% and 1%, respectively and the current spot price is ¥100 is S(1)=¥100*()=¥ The USD Carry trade profit if the yen appreciates according to IRP is (Repaying ¥1M loan in dollars, converting yen to $ in spot and investing) Financing Costs = ¥1,000,000**$(1/)/¥ =$10,300 .
